Driven by the boom in electronic trading and other technological advances, a range of upstart entrepreneurs now are doing the kind of bulk trading that up until a few years ago was practiced exclusively in upstairs trading rooms at major brokerages.
These so-called alternative trading systems, which are propagating rapidly, are often known in the art as “dark pools” because of their nebulous and murky nature. Estimated to handle about 1 out 10 shares traded each day in the U.S., dark pools are meeting a need by institutions to grab or dump stocks quietly—and anonymously.
The pools are booming in popularity as big institutional investors look for ways to trade blocks of stock without triggering ripples in the share price as can happen on traditional stock markets such as the New York Stock Exchange (NYSE) and NASDAQ. In the harsh light of a public marketplace like the floor of the NYSE, an institution trying to pull off a massive trade runs the risk of making a big splash that will move the market, but in a dark pool, a big fish can jump in without so much as a ripple.
Therefore, large brokerage firms, trading boutiques and even stock exchanges are interested in designed systems that allow shares to be bought and sold in these dark pools out of the sight of prying eyes. However, due to their proliferation, the market has become so fragmented that it may be hard to find big blocks of stock or other financial instruments to trade. So many dark pools have popped up that using them has become increasingly frustrating and time-consuming for many investors. At least forty-two such U.S. trading networks now are competing for orders, up from seven dark pools as recently as 2003.
These dozens of dark pools have created a new and wild frontier that is largely unregulated. The industry is growing so fast that regulators cannot keep up. Moreover, some observers fear these private marketplaces could take too much trading volume from the public markets—putting retail investors at a disadvantage.
What is certain is that dark pools have radically altered the way big institutions trade. And because private trading networks are extremely profitable, an array of old-line Wall Street firms is following in the footsteps of independent startups that have carved out the industry's hottest new niche.
Without the easy access granted by dark pools, big institutions would have to move big orders through the market by calling a broker who would, in turn, send that market to the floor. As the information leaked—first to the broker, then to the floor—an investor's intentions would be exposed.
But in a dark pool, a big institutional investor can shop or put a buy order out for stock without alerting a regular broker. Though alternative trading systems are not water-tight, they do minimize information leakage, traders say.
There is no doubt that pension funds, mutual funds, hedge funds and many other big institutional investors are as eager as ever to buy and sell blocks of stock without pushing prices around. As a result, dark pools are expected to account for about 10% of total daily trading volume in the U.S. in 2008, up from less than 1% in 2003. Securities firms and their clients are expected to direct about 20% of their stock orders to dark pools by 2010, up from approximately 17% in 2007-08.
In a dark pool, investors indicate their interest and either negotiate with a counterparty or get matched with one by the dark pool. Many investors put up with the confusion of using the pools and the declining order sizes on some because the trades on dark pools can still be much bigger than those done on public exchanges, from a few thousand shares to tens of thousands at a time.